Category Archives: Public Choice

The Problem with States’ Rights

This week, Eileen Norcross hosted a fiscal federalism symposium, bringing together scholars of various disciplines to discuss some of the challenges that our system of federalism faces today. Part of the discussion centered around Michael Greve’s new book The Upside-Down Constitution.

One of his key points is a reminder of the reason federalists believed that states’ rights are important. We shouldn’t care about states’ rights for the sake of states’ rights — states are merely groups of residents. Rather, we should care about people’s rights, and how these can be better protected in a federalist system than under a centralized government. This distinction sometimes gets lost when people advocate states’ rights rather than states’ enumerated powers. The problem with advocating states’ rights is that this nuance paves the way for states to collude rather than to compete.

A clear example of this collusion happened in 1984 when Congress passed the National Minimum Drinking Age Act. Because setting a drinking age does not fall under the federal government’s enumerated powers, when Congress wanted to change the rules in this area, it had to bargain using tax dollars. States that kept a drinking age in place below 21 would have lost 10-percent of their federal highway funding dollars.

While this may sound like the federal government is coercing the states, it’s key to remember that the goal of federalism is individuals’ rights. With the National Minimum Drinking Age Act, the states and federal government colluded to bring an end to competition in policy. This Act made state policy in this area the same, taking away Americans’ opportunity to choose to live in states with lower drinking ages.

When multiple levels of government pay for a given service, such as roads, many opportunities arise for this type of collusion, leading to the growth of government and the erosion of competition between governments. A competitive federalism means both that governments have incentives to provide the policy environments that their residents want and that people will have greater variety of policy climates to choose from. If the drinking age is an important issue to a family, competitive federalism could provide them with the option of living in a city or state with a higher or lower minimum age.

In the coming year, we hope to pursue research exploring what institutions limit competition within American federalism and what institutions prevent collusion between the federal, state, and local jurisdictions.

 

Government Failure and Market Failure

Chicago school economists are often maligned for their supposed blind faith in markets. And it is true that some of the theories associated with Chicago have a certain Panglossian feel to them; they give the impression that markets everywhere and always yield the best possible results.

But as Milton Friedman noted in an interview for A Modern Guide to Macroeconomics (p. 174 of the first ed.), one need not have blind faith in markets to think that government intervention will make matters worse:

I believe that what really distinguishes economists is not whether they recognize market failure, but how much importance they attach to government failure, especially when government seeks to remedy what are said to be market failures.…Speaking for myself, I do not believe that I have more faith in the equilibrating tendencies of market forces than most Keynesians, but I have far less faith than most economists, whether Keynesians or monetarists, in the ability of government to offset market failure without making matters worse.

With this, the founder of the Chicago school was articulating a notion more closely associated with the Virginia School of Political Economy than Chicago. The Virginia School emphasizes the inherent biases of public policy and the ways these biases can make government intervention fall far short of the imagined ideal:

At every step of the political process, perverse incentives ensure that economic-policy-in-reality is a far cry from economic-policy-as-it-is-ideally-envisioned. So even if there is a rationale for government correction of market failure, it is irresponsible to ignore the very real possibility that government “correction” of market failure often makes matters worse.

In a post last month, I used this line of argument to critique an article by Dylan Matthews on fiscal stimulus. I noted that if the macroeconomics of stimulus look murky, the public choice of stimulus look downright bad: the incentives of democratic politics do not encourage voters, politicians, political aids, or bureaucrats to implement stimulus as Keynesian theory says it ought to be implemented.

Yesterday, Matthews helped me make my case. In a superb post he pointed to the results of a recent survey which found that fully 15 percent of Ohio Republicans are willing to give Gov. Romney credit for killing Osama Bin Laden. To help explain this bizarre result, Matthews cited research showing ideological beliefs tend to affect voters’ assessment of objective facts. I’d note that this doesn’t mean people are dumb. It just means that the political process–in contrast with the market process–does not reward information gathering or information processing.

This should make one more skeptical of stimulus, and other government solutions.

Central Falls bankruptcy exit plan approved

In what is described as, “the quickest bankruptcy adjustment in U.S. history,” Central Falls, Rhode Island has reached an agreement to exit from bankruptcy with a plan that will fully repay bondholders (including any legal fees incurred), while slashing worker pensions by as much as 55 percent. None of Central Falls’ workers will get less than $10,000 and all will have to contribute 20 percent more for their health care until they are 65 and eligible for Medicare, according to Bloomberg News. The agreement was reached when the state promised to help supplement retiree pensions for five years.

Bondholders will be repaid via higher municipal taxes, or a four percent increase in property taxes each year for the next five years. No one escapes unscathed, except the bondholders, which is attributable to the fact that Rhode Island passed a law explicitly protecting them from municipal default last year. The bondholder protection law appears to have the intended effect with Moody’s promising to increase Central Falls’ credit rating.

Retirees are understandably upset but it’s important that the cause for plan underfunding be properly diagnosed. Accounting distortions rooted in risky discount rates are to blame. Central Falls’ Police and Fire Plan was deeply underfunded based on numbers that underestimated the liability. That is the lesson to be learned and the inescapable problem facing many other jurisdictions with defined benefit plans in the US. It is in the best interest of governments to accurately calculate their unfunded liabilities with reference to a risk-free discount rate and come up with a plan today. Waiting and gambling on a future market boom doesn’t do retirees any favors.

New video explores source of union influence in politics

The Moving Picture Institute and Reason TV have partnered on a new video that explores how public sector unions affect political outcomes. Many public sector employees are required to pay union dues, and these dues are in turn used to sway political outcomes.

As the video explains, teachers who want to teach in public schools often don’t have the option of keeping their union dues instead of funding political causes. This helps to explain the union’s incentive to grow the public sector workforce, even if the growth in spending does not result in improved outcomes for taxpayers.

The video does a clear job of explaining that the problem is not individual public employees, but rather the incentives facing the unions that they are required to belong to. This incentive structure at times leads union officials to support their own best interests even ahead of their members’. This was demonstrated in Chicago last fall when the Chicago Tribune revealed that 23 retired union officials receive benefits nearly three times greater than what the city’s typical retirees make, at the expense of not only taxpayers, but also the public employees they represent.

 

SEPTA and interest rate swaps

Interest rate swaps became a relatively popular means for municipal governments to save some money during the 1990s and into the 2000s. The basic idea is that an issuer (the government) enters into a contract with a bank to exchange interest rate payments on a cash flow. These can be structured to exchange a fixed payment for a variable payment in return, or vice versa.

These interest payments are calculated based on an underlying asset or instrument, such as a bond. That makes interest rate swaps a derivative, as their value is derived from an underlying financial instrument.

The issuer’s goal is to hedge against fluctuating interest rates and impart some stability to their budget.The bank’s incentive is to make a fee. It works for the issuer when they guess correctly and – by way of example -the issuer agrees to a payment based on a fixed rate of interest that is low relative to the adjustable rate of interest the bank pays to the municipality in return.

But that’s not what happened as rates began to fall after 2008. Many municipal issuers found themselves paying banks a fixed rate that was high relative to the variable rate the bank was paying in return. Jefferson County, Alabama is the most notorious example, as my recent article in US News explains. At work in this larger story is the role the LIBOR interest rate rigging scandal played in suppressing the variable rate leading some governments to sue banks for damages.

Pennsylvania governments were particularly keen on interest rates swaps, with 626 swaps having been entered into across the Commonwealth. Depending on how they were structured, some entities have come out ahead. The majority have lost on the contracts. That includes SEPTA, as Pennsylvania Watchdog explains.

Is the problem with the interest rate swap concept? I’d argue that the answer lies in how they are used. What might be a good hedging instrument for the financial sector exposes the public sector to a set of risks that aren’t fully appreciated. The risks -including the real hazard that the municipality incorrectly guessed the direction interest rates would travel- are passed on to taxpayers or service users.

 

 

Generational Unfairness in Pensions

California Governor Jerry Brown has led an effort to pass some changes to current state employee pension benefits that will affect new employees by raising their retirement age, capping their potential benefits, and requiring both new employees and some current workers to pay at least half of the cost of their pensions.

At Public Sector, Inc. Steve Greenhut explain that the savings from these changes won’t be felt for years to come:

It’s clear the reform would do little to touch current unfunded pension liabilities, estimated in California at as much as a half-trillion dollars, but will bring in reforms in decades after new hires start retiring.

The changes are projected to save state taxpayers between $40 billion and $60 billion. With these changes, California’s pension fund will still be underfunded by about $450 billion, calculated using the risk-free discount rate (pdf). If policymakers refuse to make further changes to the system, this remaining debt will require greater sacrifices from new workers and future taxpayers.

This unfunded liability represents generational unfairness. Today’s taxpayers are paying for current retirees who provided state services in the past. Likewise, the new reforms require sacrifices primarily from new workers. They will be receiving fewer benefits while paying into a system that benefits current workers and retirees.

States have unfunded pension liabilities due to management mistakes of the past. However, the costs of these mistakes are being felt today. Going forward policymakers should see the pain they impose on younger workers and make every effort not to repeat this pattern.

The longer that reforms are delayed, the greater inter-generational inequity grows. While California has the largest unfunded pension liability, it is not alone. Because Illinois has failed to take significant actions to address the state’s debt and pension liabilities, S&P downgraded its bond rating to A-plus with a negative outlook. This makes it S&P’s second-lowest-rated state above only California. Moody’s ranks Illinois’ bonds the lowest of all states. These ratings will be accompanied by higher bond yields on Illinois’ debt for future taxpayers. This will saddle them with more of their tax dollars going to debt service rather than current state services.

Policymakers have every incentive to engage in policies that benefit current voters at the expense of future voters because they want to receive credit for providing services that exceed their cost in the present. The only way to correct this tendency is for voters to demand that lawmakers do not force the cost of current programs onto those who do not have a voice in today’s elections.

Poway and the billion dollar capital appreciation school bond

Where does it cost $1 billion to borrow $105 million? In Poway Unified’s School District. With a pie chart showing the full cost of a $105 million capital appreciation bond being issued in a California school district to finance capital improvements, Will Carless’s local reporting turned into a national story. (Previous work on Poway’s bond financing was put together by a retired Michigan blogger, John Thurrell, who covers municipal finance).

The power of the story surely has much to do with the chart itself, which I reproduce from the original article here:

 The reason this bond is different from garden-variety school borrowing is that the district couldn’t issue a conventional bond without raising property taxes. So they “got creative.” With the help of a financial consultant they instead issued a Capital Appreciation Bond.

With a 40 year time horizon, the district doesn’t have to start making payments on it for 20 years – long after the students who enjoy the improvements have graduated. Future taxpayers will be paying bond investors about 10 times more than the initial loan.

The local taxpayer’s association calls the deal “loan-sharking,” but I also have to wonder what role property taxes and Prop 13’s limits on property tax rate hikes played in this story. Carless details how local officials figured out a way around the politically difficult choice of a tax rate hike: Proposition C. There wasn’t enough revenue coming in from the district’s $55/$1000 per assessed value levy. Proposition C asked voters if they would be willing to extend the levy for another 14 years. The idea was to collect the revenue now and start paying the bond back later. But the CAP maneuver shows that by limiting a direct and stable source of local revenues (via the property tax rate cap – which voters may modify), politicians have the incentive (and may even prefer) to pursue more exotic, and less transparent funding mechanisms.

The news story is also the power of a basic pie chart to convey information. This picture stirred up an online debate over what kinds of information citizens are given when they go to vote on bond issues. In response to the “chart-gone-viral”, the School district is defending its choice of financing while residents are “shocked” and “appalled.”

CAPs are getting a pretty bad rap in the press. One blogger calls them, “the poor community’s way to borrow their way out of insolvency,” with the “cancer spreading” to Los Angeles Unified. While California municipalities appears to have embraced CAPs, Michigan banned them in 1994. The NYT reports that U.S. school districts issued $4 billion in CAPs last year.

Strategy and politics in the of phrasing of bond referendum

How detailed should bond referendum be? The Arlington County Board heard comments from the public on the FY 2013 capital spending plan a few weeks ago. At issue was $153 million in local GO bond referendum that will be on the ballot on November 6th. The Arlington Sun Gazette reports there are four major “bundles.”

  • $31.946 million for Metro, neighborhood traffic calming, paving and other transportation projects
  • $50.533 million for parks, including the Long Bridge Park aquatics and fitness center and parkland acquisition
  • $28.306 million for Neighborhood Conservation and other “community infrastructure” projects
  • $42.62 million for design and construction of various school projects.

At issue was the language accompanying the bond packages. The Arlington County Civic Federation contends the $45 million dedicated to the acquatics center be listed as a separate item rather than bundled under the general category of park improvements.

Scott McCaffrey writes that the County Board has been bundling bonds under thematic groupings for many years as a strategy to lessen voter opposition, an interesting claim.

How explicit does language have to be in municipal General Obligation bond offerings? States typically require GO bond debt be subject to voter approval before issuance, but how does ballot language matter to the outcome?

While not addressing the matter specifically a few related questions have been pursued in the literature. Damore, Bowler and Nicholson in their paper, “Agenda Setting by Direct Democracy: Comparing the Initiative and the Referendum” (State Politics and Policy Quaterly, forthcoming) considers if agenda setters use the referendum process to extract greater spending than the median voter desires. Some of this research indicates that voters are less likely to support state referendum for tax increases but that between 1990 and 2008, 80 percent of bond referendum received voter approval.

As to the need for particular language, there are strategies. The Government Finance Officers Association (GFOA) lists six steps governments can take to improve their chances of getting a bond approved. This includes, “measure design” or “developing ballot language that appeals to voters and clearly explains how this measure addresses the particular issue targeted by the bonds meets the needs of the community.”

I did find anecdotal evidence that politicians struggle with language on ballot questions, in an effort to strike a balance between clarity and increased likelihood of passage. The Rockford Illinois School Board appears to be hemmed-in by how it phrases bond questions. The more detailed the questions the more legally-bound the board is to spend the money as specifically approved by voters.

Speaking of language, in writing this post I was unsure if I should be using”referenda” as the plural of “referendum”. “Referenda” sounds more natural to me but “referendum” appears to be used more often.

Given the difficulty of the original Latin grammar (referendum is a “gerund” and has no plural), it turns out there is an unsettled debate over this. Either is correct according to the Irish paper The Daily Edge. I felt better knowing that even The British Parliament debated over which plural form to use back in 1998. It turns out whether one uses the Latin “referenda” or the Anglicized “referendum” is purely a matter of taste.

Is the mortgage crisis to blame for San Bernardino’s bankruptcy?

The LA Times contains a new kind of argument on why cities like Stockton and San Bernardino are in bankruptcy. To date, politicians, analysts and journalists have drawn a direct line from rising employee costs and declining revenues to municipal fiscal stress. Harold Meyerson takes another path to reach his own destination – to burnish the image of unions and  politicians. His bankruptcy diagnosis gets lost along the way.

He blames the banks. These cities went bankrupt because, “banks were peddling subprime mortgages to poorly-paid workers.” While the banks are certainly involved in the economic and fiscal train wreck he is upfront that the goal is to weave a counter-narrative, challenging the “right and center right” story of fiscal irresponsibility and overpaid public employees.

The problem with narratives (on either the right or the left) is when they cobble together related events and actors without a theoretical framework and empirical evidence. Mr. Meyerson is holding several of the puzzle pieces but then forces them together without regard to how they fit.

Some puzzle pieces he correctly identifies: a housing bubble, the role of banks, the economic fortunes of the Inland Empire, and the fiscal effects of California’s Proposition 13. What he airbrushes or ignores are the roles of Fed Policy, government lending, regulatory and land-use interventions, the short-term incentives of politicians, the hand of special interests, unions, and erroneous accounting assumptions that generated the perfect storm for a fiscal fallout in 2008.

Stockton’s troubles are plain for all to see. Steven Malanga discusses them here. The municipality’s spending spree can be traced to an overheated housing market which drove Bay Area homebuyers into Stockton in search of cheaper properties. That lead to a 20 percent population growth and a surge in property tax revenues fueling Stockton’s appetite for redevelopment. In 2003 the city borrowed for a waterfront revitalization and a 5000-seat sports arena. They bonded for pension enhancements. In total the city issued $700 million in debt.

Part of the pension deal allowed workers to retire at 50 with 90 percent of their final pay plus COLAs. To pay for this, Stockton invested some bond proceeds into CALpers on the bet it would earn more than the interest payments on that debt. They lost that bet. The housing boom – itself the creation of decades of government interventions – created the mirage of ever-increasing revenues that encouraged politicians to play fast and loose with bonds and future promises to workers.

The next claim is that defined benefit plans have been “demonized” also misses the mark. Defined benefit plans – or annuities – have been destroyed by those who champion them most loudly. Faulty government actuarial assumptions made them appear cheap to operate. That encourage politicians to offer workers (in union negotiations) increasingly generous retirement terms all while underfunding those benefits and taking risks with plan assets. This is accounting chicanery, and sadly, it was not (and still isn’t fully) recognized as such. The blame there can be pinned on the esoteric but well-documented trouble with defined benefit pension accounting. This case has been made in great technical detail by economists and practitioners.

The right salary for a public worker can really only be determined with reference to a private sector counterpart. It isn’t backed into based on area housing prices. Biggs and Richwine find public teacher salaries are on par with a private sector counterpart (in terms of SAT scores and skills). But, salary is only one component of total compensation for public sector workers. Compensation also includes (undervalued and underfunded) pension benefits and (largely unfunded) health benefits. Public sector compensation is a big and growing part of many municipal budgets. What can be said is that the cost of San Bernardino’s police and firefighters represent three-quarters of the city’s expenditures and revenues are flat.

Again, Meyerson is holding one of the right puzzle pieces: the revenue bust that followed the housing bubble. But he fails to note that it was the government-induced housing bubble and subsequent revenue boom that tempted public officials to overextend themselves. This house of cards was supported by flawed accounting and incentivized by short-term gains. This is why to make those pieces fit one needs a theory and empirics otherwise the diagnosis of San Bernardino’s and Stockton’s bankruptcy is cast aside in service of the meme. It is “politics with romance.”

What caused these two cities to tank? A host of economic and fiscal factors and scores of regulatory interventions over many decades. Some of that can be found in the accounts and CAFRs. They are no fun to comb over but they reveal choices, bargains, and tradeoffs under constraints and contain the record of the evasions and faulty assumptions of “public choosers.”

To Regulate or to Tax

It has now been a week since the Supreme Court handed down its long-awaited ruling on the ACA. From an individual liberty perspective, it was either a dark cloud with a silver lining or a dark cloud with a dark lining.

I am not a constitutional scholar (though like many Americans, I have spent the last week playing one on Facebook), so I’ll spare you my legal interpretation. But what can we say about the political economy of the decision?

For one thing, the decision highlights the fact that fiscal and regulatory policies can be substitutes for one another. As George Mason University economist Richard Wagner put it some 20 years ago, “a central principle of public finance is that any statute or regulation can be translated into a budgetary equivalent.”

For example, Congress might have passed the individual procreation mandate. It might have fined every childless couple $3,000, every couple with one child $2,000, every couple with two kids $1,000 and every couple with three or more kids $0. Congress, of course, didn’t do this. Instead, they went the fiscal route and created the per-child tax credit, the marginal incentives of which are identical to what I have just described (up to the first three kids).

Alternatively, Congress might have imposed a tax on employers equal to $12,100 for each employee not paid $7.25 an hour. Instead, they went the regulatory route and created the federal minimum wage, the marginal incentives of which are identical to such a tax.

In my paper with Noel Johnson and Steven Yamarik, we explore the inherent substitutability of fiscal and regulatory instruments. Specifically, we look at state behavior in the presence of fiscal limits. We are interested in whether politicians substitute into regulatory policy when fiscal rules bind their decisions (we find evidence that they do). The ACA ruling essentially gets at the opposite phenomenon: the Court has ensured that Congress’s regulatory hands are relatively more constrained. Does this mean that Congress will substitute into fiscal policy, using taxes, tax credits, and spending to address questions that they might have addressed with regulatory instruments? My guess would be: yes.